Many people bandy about the definitions of “disruptive technology” or “the innovator’s dilemma” without ever having read the book and almost universally misunderstand the concepts.

Let me start with Professor Christensen’s definition:

“An innovation that is disruptive allows a whole new population of consumers access to a product or service that was historically only accessible to consumers with a lot of money or a lot of skill.”

Professor Christensen uses real data from the disk drive industry to make his points. Reading it felt like read a university book for an economics class and no wonder since he’s a professor at Harvard Business School. It is not a beach novel to be sure. The framework of his book has profoundly altered how I think about the technology market and affects how I thought about building my businesses and how I think about investing in venture capital.

The thesis of the book is that incumbents in markets – especially large and well entrenched markets – seldom survive fundamental technology changes in their industries. In a world where we’ve seen newspapers crumbling, record labels struggling and Blockbuster imploding and making way for the rise of Netflix it seems kinda intuitive to most of us but we can’t quite place why this happens.

But understanding the framework rather than just thinking “those dumb fucks don’t get it” is very useful for thinking about how markets evolve. It should affect how you think if you are an incumbent but also if you’re a startup.

Let’s start with the incumbents position in a market. I’ve characterized it in a chart below. It is often the situation that the incumbent offers a product that is vastly superior in the market in terms of performance or functionality. This is important because the customers they serve (the red line) demand a product that meets their complex requirements.

Think of incumbent line as Siebel and the red line as the large enterprise customers that they served who demanded 1,800 features and sent out RFPs with checklists that had to be ticked off to even be in the running for their business.

When new companies enter the market they really have no chance to initially unseat the incumbents because the performance gap is too large and the costs / time of catching up too unachievable. In fact, the incumbent is usually very dismissive of this new competition as our the large buyers of the incumbent’s products.

And weirdly the buyers of this technology often have a vested interest in buying from the incumbent. They see it as a source of differentiation for them as a company because their less financed competitors can’t afford it (and often their careers are wrapped up in the multi-millions of dollars they’ve spent implementing it). In short, they ain’t just gonna throw that away for some new fangled tech toy.

So the startups tend to focus on totally new customers. They try to capture people that didn’t buy the expensive stuff in the first place because they couldn’t afford it. Often the startups are actually serving a slightly different kind of customer or a slightly different market need. The thing about “disruptive” technology as I interpret it is NOT that it is a major breakthrough in performance or functionality as most people conceive it. It is often LESS performant. What is “disruptive” is that is also dramatically less expensive. And the providers take a much lower margin – they have nothing to lose, nothing to protect.

Enter Salesforce.com. In 1999-2000 they weren’t doing enterprise-wide installations at Merrill Lynch, Dell and Cisco. That would have been laughable. They were serving a latent market need for mid-sized businesses to use CRM. They offered a product that didn’t even try to compare with Siebel. In fact, they tried to totally redefine the market. ”Siebel cost you $2 million and 18 months to implement? How about $30,000 and 3 weeks?” They didn’t exactly grap the top end of the market.

So what did happen? And what does happen in many other industries? First, over time Salesforce.com’s technology got better and better yet the price didn’t shoot up dramatically relative to Siebel. And after a few years enterprise customers started looking at the cost disparity and saying, “maybe Salesforce.com is good enough to meet our requirements?”

Incumbents feel threatened. Often their response isn’t to radically cut cost and try to hold on to customers. They can’t. They have big installed bases. They have existing customers who already paid big prices who would be seriously pissed off if the next guy bought the same thing for 10x less. The incumbents have expensive product features to maintain and often expensive sales channels. Think Compaq when Dell first went direct over the phone then Internet.

And if the incumbent did dramatically cut costs all they would seemingly do is start following the lead of the new entrant? There you have the innovator’s dilemma. The incumbents curse. You can’t take a $5 billion revenue stream and say “Fuck it. They’re going to eat our lunch anyways – let’s just cut our revenue to $1.5 billion and wipe ‘em out.”

So they do the opposite. The increase spending on features / performance / functionality. They gather with their cadre of high-requirement customers and have planning sessions about how they can make even more performant products.

But here’s the thing. Often customer requirements don’t grow exponentially relative to their existing line. And as you trace the red line in the graph above as it gets closer and closer over time to the new entrants functional offering there is a huge and rapid sucking sound that pulls the bottom out of the market as waves of customers “trade down.” And Salesforce.com becomes a $15 billion company doing $1.2 billion in recurring run-rate revenue and growing while Siebel is sold to Oracle for a mere $5.8 billion.

The take aways for me are:

The incumbent eventually realizes what is happening to them. They are run by smart & shrewd people or they wouldn’t become leaders in incumbent organizations in the first place

They are blinded for too long – reinforced by big revenues & profits that come from customers that corroborate their misinformed views of the future because they have a shared & vested stake in status quo

Disruptive technologies are often those the are less performant and feel “chintzey” relative to their well-heeled competitors. They are radically lower in price. They initially create deflationary pressures in a market. They are nearly impossible to react to. But while the price points are dramatically lower this often encourages more users, more innovation in the eco-system and therefore often a bigger market opportunity than even the incumbents perceived

I am reminded about how dismissive traditionally television media is about YouTube – even to this day. About how dismissive traditional print was about blogs or the airlines views the “peanut serving” Southwest Airlines. About how Microsoft viewed Google Apps. Sony, the iPod. US automakers made the mistake with the “low end” Japanese manufactures until the Toyota became the Lexus. What future have telcos for call-based revenue in the era of Skype?

I know that Clay Christensen has written a book that proposes solutions for incumbents. I haven’t read it. Maybe I should. But anecdotal evidence tells me that incumbents eventually struggle to massively disrupt their own large and profitable businesses – that change has got to come from outside. Some have tried to artificially create “innovation labs” from within but I struggle to believe that this model will work for disruption.

Perhaps the best they can do is to help fund their successors. Perhaps they can spawn the next generation of innovators and leave a footprint of their DNA along the way. Or at least diversify the future fortunes of their shareholders in the way that Yahoo! earned handsomely from Google’s success. I don’t know – it may not be intellectually or emotionally possible.

But if I studied every incumbent industry around me and saw the destruction that technology and the Internet was bringing I would at least want to have an ownership stake in my pillager’s future cashflows if I knew the sacking of the castle was inevitable.

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2x startup Founder & CEO who has gone to the Dark Side of VC. His first company, BuildOnline was sold in 2005, his second, Koral was acquired by Salesforce.com and became known as Salesforce Content, while Mark served as VP Product Management. In 2007 Mark joined GRP Partners in 2007 as a General Partner. He focuses on early-stage technology companies, usually looking at Series A investment, and blogs at the aptly titled Both Sides of the Table.

3 responses to “Understanding How The Innovator’s Dilemma Affects You”

If you are interested in using academic frameworks such a Christensen’s to understand IT industry’s evolution, and in particular the cloud industry, I’d like to share my ideas with you.
I actually wrote a whole blog post a while ago in which I go beyond Christensen’s frameworks to try to explain the cloud as a technological innovation: http://germanretana.net/2010/08/the-cloud-as-a-technological-innovation/

In particular, regarding Christensen’s ideas, I believe that “What the cloud has done new is to offer the servers, storage, development platforms, and software applications as “cheaper, simple, more convenient products or services that start by meeting the needs of less-demanding customers” (Christensen et al., 2000). Christensen’s concept of a disruptive innovation (Christensen, 1997) matches the fact that most of the cloud’s early adopters are startups and small vendors.”